LONDON, Oct 2 (Reuters) - The euro fell towards a five-week low on Tuesday after a senior official from Italy’s ruling party said most of the country’s problems would be resolved if it scrapped the euro for its own currency.

Markets are highly sensitive to Italian political developments after the ruling parties proposed a budget with a higher-than-expected deficit target, exacerbating tensions with other euro zone leaders and worrying investors who want Rome to bring its large debts under control.

The euro’s weakness combined with another push higher by the dollar, as investors shrugged off signs dollar long positions had become stretched to buy into the U.S. currency.

“We are dealing with a war of words, with the euro on one side and Italy on the other ... There’s a lot of headline risk about,” said Valentin Marinov, head of G10 FX Strategy at Credit Agricole.

Marinov, however, said he did not expect the Italian saga to weigh heavily on the euro in the medium term because there was “no real evidence of contagion” that would worry the European Central Bank and prompt it to postpone a gradual end to its fiscal stimulus.

The euro skidded half a percent to as low as $1.1525, almost its weakest since Aug 21.

Most of the losses came after Claudio Borghi, the economic head of the ruling League party, said Italy would enjoy more favourable economic conditions outside the euro zone .

Italian Deputy Prime Minister Luigi Di Maio, who has accused European Union officials of deliberately upsetting financial markets with negative comments about Italy’s budget plans, also said Italy would not change its budget deficit targets .

The euro also fell against the Swiss franc, often bought as a safe haven in times of market flux, which added 0.4 percent to reach 1.1347 francs.

The dollar extended gains as risk appetite faded, after it got a boost from the U.S.-Canada trade deal to replace the North American Free Trade Agreement.

The dollar index rose 0.3 percent to 95.542, trading at a three-week high.

Fears about international trade conflicts between the United States and major trading partners, including China, have lifted the dollar this year, as has an increasingly confident U.S. Federal Reserve.

Flows from investors buying U.S. government bonds and stocks have also underpinned dollar demand, analysts say.

AUSSIE FALLS

Against the Japanese yen, the dollar fell 0.2 percent to 113.74 yen as dollar bulls booked some profits.

Following the U.S.-Canada trade deal announced on Monday, the yen fell as low as 114.06 per dollar, its weakest since November 2017.

“If we close this week above 114, that’s going to be a significant milestone,” said Bart Wakabayashi, Tokyo branch manager at State Street Bank.

The Australian dollar fell half a percent to $0.7194 after the Reserve Bank of Australia held interest rates at 1.5 percent after its October policy meeting, a widely expected decision given inflation and wage growth continue to disappoint.

The Aussie, often viewed as a barometer of risk appetite, was expected to do well out of the U.S.-Canada trade deal but dollar demand and the central bank decision sent it lower on Tuesday.

The Canadian traded flat at C$1.2821 per dollar, holding onto most of its 0.7 percent gains the previous day.

The British pound dropped 0.4 percent to as low as $1.2990, a three-week low. (Additional reporting by Daniel Leussink in Tokyo, editing by Larry King)